I enjoyed reading about Benjamin Graham’s career. He shared his Wall Street experiences in the classroom and in his best-selling book, told readers lessons he learned in life.
Graham knew math and since his only tool was a slide rule, he had to keep things simple. Unlike today, he didn’t have the time or tools to help him perform complex algorithms.
Ben spent his life trying to simplify procedures. When he presented his ideas to colleges and Wall Street, firms weren’t interested because they couldn’t charge big fees and salaries if they only did simple things.
Investments and the Investing Environment
After years of experience, I found there were three parts of investing: the investor, the investments and the investing environment. These ingredients heavily influence investment price movements.
Graham presented concepts to select profitable investments and Charles Dow developed concepts to profitably navigate the investing environment. An investor needs to know both concepts.
I’ve always thought of Benjamin Graham as the father of fundamental analysis and Charles H. Dow’s “Dow Theory” (the name given to Dow’s writings in a 1903 book by S.A. Nelson called The ABC of Stock Speculation) as the father of modern technical analysis. They were a great team because they both were concerned with finding value. Dow had his “element of chance” and Graham had his “margin of error.”
Graham’s concept helps investors look at company fundamentals to decide what stock to buy. Dow’s Theory helps investors understand when the market is ready to rise. A good value stock in a rising market and a growing economy typically yields the best profits with a minimal amount of risk.
I find it interesting that both Graham’s and Dow’s approach to stocks and the markets are basically ignored by Wall Street firms as well as the academic world, even though the use of both concepts have been profitable for many users. I know these concepts will be just as valuable in the future as they are now.
Graham’s Yardstick for Performance For Investments
Graham considered the following factors essential in business:
1. Profitability – the ratio of operating income to sales.
2. Stability earnings growth over ten years, when compared to the last three years.
3. Earnings growth as compared to the Dow Jones Industrial average as a whole.
4. Financial position (equity to debt ratio of 2 to 1).
5. History of paying dividends without interruption: even better if they grow over time.
6. Price history: regular appreciation over time.
The Graham & Dodd P/E Matrix
Graham developed a stock valuation model based on future earnings growth and a AAA corporate bond rate. 0% growth had a P/E of 8.5. P/E=8.5 +2G. G is the expected rate of earnings growth over the next 5 years. Changes in interest rates and growth change P/Es and price valuations.
Dow Theory For the Investing Environment
Charles Dow began tracking a railroad average in the 1880s and later added industrial average. Both
averages needed point in the same direction for an up-trend or down-trend.
When averages are not tracking in the same direction, it is known as non-confirmation and the current direction is likely to end.
The logic behind Dow’s theory is economic. If the markets are rising, the economy is growing; stores are ordering goods to sell. When sales decline, stores order fewer items, which means fewer goods are shipped, transportation slows, which causing a non-confirmation. A Dow sell signal occurs when both averages fall below their previous lows and the rising trend is reversed.